The Biggest Risk for Early Retirees

How You're Underestimating Your “Personal Inflation Rate”

What is Financial Independence, Retire Early (FIRE)?

FIRE is the most influential personal finance concept since the great recession of 2008–2009. Put in its most basic terms, FIRE is the point where your passive income exceeds your living expenses.

When this happens, you are said to have reached “Financial Independence”. The term comes from the idea that you are no longer dependent upon your job to pay for your living expenses. At this point, many people choose to retire early. Hence “Financial Independence, Retire Early”.

How Does Someone Achieve Financial Independence?

The most influential person in the FIRE community is a personal finance blogger known as Mr. Money Moustache. His blog post from 2012 lays out the “Shockingly Simple Math Behind Early Retirement”.

Mr. Money Moustache explains that the path to FIRE comes down to only one variable — your savings rate. The amount of your take-home pay you invest determines how long it takes to reach FIRE.

This is demonstrated in the chart below. The left-hand column shows your savings rate and the right-hand column is your working years until FIRE.

If you save 5% of your take-home pay (what you net after taxes and deductions) it will take you 66 years to reach FIRE. If you save 85% of your take-home pay it will take you 4 years to retire.

Assumptions Behind this Shockingly Simple Math

The brilliance behind the above chart is its simplicity. Far too often personal finance bloggers (like myself) get too bogged down in the complex details behind investing and personal finance.

The math behind FIRE is so appealing because it is so simple “If I save X% of my paycheck, I can retire in Y years.”

Part of the reason the math is so simple is because Mr. Money Moustache has done all the hard math for you and presented the results in a single table. There are however some very important assumptions made to produce this simple math.

Assumption 1: You can earn a 5% return on investment after inflation during your saving years.

Assumption 2: You’ll use the 4% rule after you retire to live off your investments.

Assumption 3: Since early retirement might mean living off your investments for 50–80 years, Mr. Money Moustache advises early retirees only live off the gains in your investments.

All the math behind FIRE relies on the assumption that you can earn more than 5% above inflation on your investments during retirement.

That leads us to a potentially scary question.

What If This Assumption Does Not Hold Up?

5% above inflation might not seem like a huge return. That is because over the past 10 years the S&P 500 has tripled in value and inflation has hovered around 2%.

What would happen however if inflation increased at a higher rate in the future and/or the stock market entered a prolonged period of low returns?

That is one of the questions explored in a paper by Angela Antonelli, executive director of the Georgetown University Center for Retirement Initiatives.

If inflation is 2%, the math behind FIRE says you would need to earn an average of 7% per year on your investments.

If inflation is 6% you would need to earn an average of 11% per year on your investments.

The last time the U.S experienced 6% inflation was in 1990. So, while it is unlikely we will see inflation rates at that level, it is entirely possible we could return to those levels at some point in the future.

Furthermore, it is not the national inflation rate that matters most, it is your “personal inflation rate” that will impact your own math behind early retirement.

If you retire early as a perfectly healthy 37-year-old, your personal medical bills might be close to \$0. If you retire at 37 and assume only a 2%-3% rate of inflation, you might run into serious trouble down the road.

One study found that the average senior citizen (65 or older) spends \$18,424 per year on medical bills.

Medical bills can throw cold water on the math behind FIRE. Especially for those pursuing early retirement while living in the U.S which has some of the highest medical costs of developed countries.

I don’t say this to discourage you from pursuing FIRE. I say this so that you make sure that while you pursue FIRE, you look hard at the assumptions you are making, particularly as it pertains to your future medical costs.

I will be dedicating future articles to discuss financial planning for future medical expenses. I think it is the single most overlooked variable by those in the FIRE community.

I would love to hear from you. Are you pursuing FIRE or already pulled the trigger on FIRE? Have you factored in future medical expenses? How are you saving and planning to pay for those future expenses? I would love to discuss in the comments.